Saturday, August 15, 2020

Problems of small businesses from a company law perspective

In a perfect world, those who invest their hard earned money into small businesses ought to be aware of many of the very common types of problems that may be encountered where the corporate form is chosen as an investment vehicle. It being an imperfect world, most small businesses are incorporated on the advice of accountants rather than lawyers, in more or less the same way that most marriages take place on the advice of pastors rather than lawyers. Consequently, the dynamics of power struggles are downplayed. Predictably, a lawyer’s intervention is sought if a small business is experiencing much trouble, just as in the case of a disorderly marriage. Then, intervention is often too little too late.

Small companies range in size and nature but often, like marriages, involve small or extended families (husband, wife, grannies) to business associates with or without investors who do not participate in management. In most small companies, the shareholders are also the directors, and small companies are, in reality, little more than close partnerships. Like a marriage, any distressing or emotionally disturbing experience will tear the company asunder, the outcome being total collapse.

It is desirable that investors in small companies be familiar with problems likely to be encountered, given the popularity of the small company in recent years. As all of us are too often aware, quality legal advice costs an arm and a leg; gratuitous advice can nevertheless be quality advice.

My plea, though, is that the readers show tolerance toward this commentary where my intentions may be less than perfectly realized, and that they bring their own entrepreneurial experience to bear in reading the commentary.

I have not carried out empirical research (nor am I aware of any) on the large number of small companies incorporated, or liquidated, annually. I do not have any direct evidence which might have led to my conclusion regarding statistical data, or reasons for their demise. I have simply gathered my information from official reports or by reading the business section of various newspapers and accepted it because someone says this is the case. What is expressed is not an activity which has been perceived, but a proposition that has been cognitively accepted.

To illustrate the kind of problems encountered in small companies, two examples will be sufficient: capital and shares. The small company is normally set up as a private company limited by shares to carry on a business endeavour. For some reason (and I could not tell you why), the authorized share capital is often limited to P3 000 broken up into numerous shares (usually 3 000), with each share bearing a nominal or minimum value of P1.00. The company’s promoters, all of them also its directors, usually agree to take the company’s shares in equal or differing proportions. Often, the company has only one class of shareholders. Sometimes the promoters (directors and shareholders) do not contribute to the company’s capital in cash. They may decide to have personal assets (guarantees, fixed deposit, property) bonded, in exchange for the company’s shares, to enable the company to borrow from a lending agency.

This hypothetical illustration masks several problems. First, the company’s share capital is limited to a small amount (P3 000) compared to the larger amount it has borrowed or invested in.

Second, shares may not be issued beyond limits of that capital. Third, the company could be held to be operating illegitimately because of a negative shareholders’ equity. Therefore, the company’s board of directors would be well advised to increase its share capital to a figure that realistically reflects equity, a feat accomplished by way of resolution. At the same time, the directors should formally adjust the allotment of shares, and file proper documentation with the companies’ registrar.
A question that arises is the validity of a transaction in which a company has accepted payment for its shares not in money, but in money’s worth.

Another question is where directors have issued shares allegedly for an ulterior motive. Either of the two transactions can lead to an impasse between directors and shareholders (this becomes complicated if directors are also shareholders). The outcome can be protracted, costly legal proceedings negatively impacting on the company’s business. Anyone investing in a small company must first thoroughly read its memorandum and articles of association or seek professional advice.

This is because the relationship between a company’s organs, or its functionality, is determined by examining the text of these detailed papers conjunctively with the Companies Act.
If we examine the company’s institutional structure in the articles, we notice that the board and the shareholders in general meeting are the two principal organs. Typically, the board manages the company’s business and the general meeting can approve or ratify the board’s actions, or formulate company policy. The distribution of powers and functions is regulated by the Companies Act, the memorandum, and the articles. Once an organ is assigned certain powers, these powers cannot be usurped by another.

In many small companies, there is a major shareholder who is also a director and managing director. He or she may also function as board chair and chair of the shareholders in general meeting. A shareholder who has invested more than other shareholders in a company naturally wields immense power, disadvantaging those others. This is a fact of life, but though it makes perfect sense, such an arrangement is often a cause for grave concern and can give rise to corporate governance issues (yes, even in small companies). The analogy is a marriage dominated by the breadwinner. This dynamic is often addressed by a shareholders’ agreement.

Where one person holds the majority of shares such shareholding translates into control. This invariably leads to tension between management and shareholders, or shareholders inter se.

Nevertheless, the situation must be regarded as normal, like in any other power relationship. Also, tension is a feature of relations whether shareholders participate in management or do not. The powers and functions of the board and the shareholders must be kept distinct and separate if tension is to diminish (I doubt if it can be eradicated).

The significance of a capital structure must not be lost. Unless shareholders agree that benefits deriving from shares are to be proportional to the capital each shareholder has undertaken to contribute, it follows that the interests of shareholders in respect of their shares as regards everything must be equal. In other words, each shareholder has an equal right to the vote, share in profits, return of capital, or surplus.

A contrary result can be achieved by the articles or special resolution. Often, the company’s articles confer a right on directors to attach rights or restrictions to shares, dividend, voting, return of capital, etc. Directors will determine that an allotment (whether capital contribution is money or otherwise) is to be proportional and must correspond to the extent of each shareholder’s risk exposure vis-├á-vis the company’s secured debts. The point is that a company may have different classes of shares with differing rights and restrictions, and the extent of a shareholder’s entitlement to share in distributions and vote at meetings are all related to the number and class of shares that he or she holds, if specified in the articles or specially agreed on.

Membership of a company is based on an undertaking to contribute capital to the company. In terms of legislation, a company’s shares may be fully or partly paid for in money or money’s worth. In other words, a company may accept payment in cash or in kind for allotting its shares, e.g. services rendered, collateral, etc. The capital to be contributed is a matter that should be agreed between each shareholder and the company through its directors. Once the agreed capital has been contributed, or the agreed security furnished, the company (or its creditors) cannot demand a further contribution, in whatever form.

It is also important to note that where shares are issued by the company for non-cash consideration, the directors’ valuation of the property or collateral is final except where the consideration is manifestly inadequate or the directors have acted in bad faith. If the company is wound up when it is solvent then the contributed capital may be returned to shareholders.

To comprehend risk, if a company has to be wound up when it is insolvent then all the assets acquired with the shareholders’ contributed capital would have to be applied to settling the company’s debts. Nothing will be returned to them (except if they are creditors), including their tied personal assets.
There is always a danger that some shareholders can default in providing their family property as collateral, as agreed, thus placing the entire investment in serious jeopardy. The company’s directors can compel the defaulter by resolution, or, this failing, by applying for appropriate judicial relief.

Lastly, can directors transact shares primarily to gain control of a company? That would be a serious breach of directors’ fiduciary duties. In small companies, the most important power directors have is to issue shares. This is called a fiduciary power, and its exercise must be in good faith for the benefit of the company as a whole. An issue of shares will be invalid where it is shown that the directors have issued shares out of self-interest, e.g. to gain or retain control.

Where such a complaint is brought before court, the court will examine the facts and establish the purpose for which the issue was made before deciding whether the issue was proper or improper. Where an issue of shares has been made for improper purpose, it can still be ratified by the General Meeting.

Our discussion of the problems of small companies is by no means exhaustive, and doubtless as the business grows other problems will be added to those already existing. The methods mentioned (powers and functions, capital increase, class shares, shareholders’ agreement), are at least useful aids in resolving particular problems. The reader will realize that some methods are more appropriate than others for a particular purpose.

Michael Mothobi can be contacted by email at [email protected]

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